Alternative investments are growing dramatically and are forecast to hit $18.1trn in assets by 2020, up from $10trn today, according to the PwC consultancy team Strategy&.
This growth is creating challenges and opportunities for service providers that have developed their capabilities and systems to cope with the additional complexity of alternatives, such as more numerous data sources and new regulatory requirements that demand operational accuracy and timeliness.
For the hedge fund and alternative credit sectors, the Cayman Islands is still the largest fund domicile by far with some 80-85% of global market share. It captured this segment of the fund business 25 years ago on the back of its internationally-recognised common law legal system and tax-neutral platform for investment structures.
Other jurisdictions such as the British Virgin Islands (BVI), Bermuda and Jersey, which could have competed more strongly, were slow off the mark.
The Cayman Islands’ position in the market has been protected by it being conveniently situated for the US market in terms of its time zone and flight connections, having relatively good connections with the UK and maintaining a stable political and economic environment.
It also has an effective court system with the oversight of a governor who is a representative of the British Crown. The authorities have also been careful to safeguard its reputation as a respectable financial centre fully compliant with anti-money laundering and other financial crime standards, tax information exchange agreements and transparency of ownership requirements.
There is a high level of confidence about Cayman Islands fund structures, and George Town has long boasted household names among its service providers and law firms.
Gradually, however, the demands of the tighter regulatory environment and focus on issues such as liquidity management, risk management, transparency and failure resolution are eroding the traditional cost advantages of offshore jurisdictions and levelling-up costs everywhere.
“Irrespective of the asset classes, we see the trend of managers and funds moving onshore,” says Peter Jakubicka, business development manager, Circle Investment Support Services.
“Asian managers still tend to prefer offshore jurisdictions, mainly the BVI and Cayman.
Fund centres need to offer the core attributes of staff with good skills, a critical mass of providers, suitable legal and regulatory environments and a convenient geography. But political stability, independence and an excellent reputation for compliance with international standards have become more important in recent years.
The industry, regulators and government of each fund centre work closely together to foster a competitive product offering. However, there is no general requirement for a fund’s domicile, administration and management to be performed in the same jurisdiction, and little heed is paid to regimes that seek to impose this.
The administration function in particular has become more global and is performed in a range of centres such as Ireland, the US, Luxembourg or Cayman.
DISPERSED SERVICE MODELS
The complexities of alternatives are a consideration in administration decisions.
“Funds are looking for service providers that can perform a wide range of functions and so if they then identify an administration services group that has the requisite abilities and experience, it does not matter too much where the group has located its administration unit and how it provides support services to it, though a significant difference in time zones would be a negative factor,” says Paul Hale, managing director, global head of tax affairs of Aima.
“The administrators may be based in Cayman, but much of the work is done in a variety of other locations including Toronto, Ireland and India and various locations in the US,” says Mike Greenstein, US alternative asset management leader at PwC, in New York.
“Some have a dispersed service model, while others do everything in one location to foster collaboration. Their location strategy will be impacted by a variety of factors including their cost model, and their service model. Other factors include time zone, language and depth of talent and expertise.”
According to the eVestment Alternative Fund Administration Survey 2017, third-party administrators have gained traction in private equity and tangible assets.
Mergers and acquisition activity in the fund administration arena has been strong and is expected to continue, driven by economies of scale, expanding geographical footprint and building product expertise.
Developments such as the Common Reporting Standard (CRS) and AIFMD have been seen as an opportunity because while compliance and regulatory consulting is expensive to build out, it is a significant source of added value, particularly for administrators with multi-national clients.
While the growing sophistication of the industry is something of a barrier to entry, by the same token new entrants are expected in niche areas such as private equity, real estate and product support to take up the slack from larger firms that are moving away from service-oriented businesses.
This is creating a bifurcation in the fund administration market between large operations and niche players.
The investment management function is situated in locations that have a suitable financial services infrastructure for the chosen investment strategy, good communication and travel connections and which are attractive places to work and live.
They must also have regulatory and tax regimes that do not impinge on the management style of funds. Hedge fund management is predominantly based in the US, followed by the UK, with Asia Pacific centres such as Hong Kong and Singapore making efforts to grow their presence.
For some asset managers, the flexibility of the legal and regulatory environment for funds, for facilitating time to market, can be the determining factor. Whether funds can access double tax treaties may also develop as a key criterion in the next few years.
Although alternatives have been the most rapidly developing area in recent times, there is little evidence that these changes have had much impact on the design of the structures selected.
Flavour of the day in the alternative space is still unregulated vehicles, as evidenced by the related structures gaining traction, such as reserved alternative investment funds (Raifs) and special limited partnerships (SCSps) in Luxembourg and fonds voor gemene rekening (FGRs) in the Netherlands.
Luxembourg’s Raifs were introduced in 2013 in response to the limitations of the société en commandite simple (SCS), which was based on the 1915 company law, to offer a competitive answer to the UK, Delaware and Cayman limited partnership structures.
They are manager-supervised vehicles that do not need to be authorised by the Luxembourg Supervisory Commission for the financial sector.
In terms of speed and cost to market, this is attractive. It allows Luxembourg to compete in terms of structuring flexibility with the traditional offshore jurisdictions, such as Cayman and the Channel Islands, but with access to the European market as it complies with AIFMD requirements.
At the same time, a new structure in the form of a special limited partnership (SCSp) was introduced, which has been of particular interest to Anglo-Saxon managers and investors given their familiarity with limited partnership structures.
However, unlike partnership structures in other jurisdictions such as the UK, the general partner is not obliged to disclose the identity of every limited partner in the partnership, and there is flexibility around voting rights and profit participation.
This has attracted real estate, debt funds and private equity structures that historically would have chosen the UK.
The Luxembourgian structure appeals to managers, particularly outside Europe, in the US and Asia, who traditionally chose offshore locations, but can now attract investors with a similar vehicle that is subject to regulation and is based onshore, which makes for a more compelling proposition.
Since 2013, more than 1,400 limited partnerships have been established.
Another trend is for fund managers to launch funds out of two centres concurrently.
“Traditionally for hedge funds, Cayman has been the clear leader and while there has been talk of funds re-domiciling, our experience is that they are not relocating away from Cayman, but what is emerging is (setting up) alternative product structures in Ireland and Luxembourg which managers then run in parallel,” says Greenstein.
“We have tended to think of the choice of domicile as a fixed pie but, in practice, funds are setting up in Cayman and also in other jurisdictions to attract different groups of investors. Certain investors prefer Cayman while other investors may prefer to be EUbased for tax or regulatory reasons.”
In deciding where to domicile their offshore funds, managers look for a tax neutral jurisdiction that has products and structures that are well-understood by both managers and investors, according to Greenstein.
“They also look for a deep pool of experienced service providers such as auditors, directors, lawyers and administrators to support the establishment and maintenance of the products.”
Another trend is competition from the new pretenders. Fund centres such as Cayman, Ireland and Luxembourg are having to defend market share against each other but also face competition from domiciles emerging elsewhere – such as Singapore and Hong Kong, though these are not yet seen as credible contenders.
In terms of investment management, the Asia Pacific countries are increasingly encroaching as there is rising interest both in investing in the region and marketing funds to local customers.
“The alternative investment funds industry faces challenges as regulatory and tax regimes change around the world, the compliance requirements of investors increase, and, not least, investment returns are hard-earned,” adds Hale.
“The established fund and asset management jurisdictions such as Cayman, Ireland and the UK must continue to improve their legal and physical infrastructure that the industry requires to operate efficiently while emerging centres such as Singapore and Hong Kong will be looking to attract businesses to the Asia Pacific region.”